January 29, 2024

By Daniel Masuda Lehrman, CFP®, CSLP®

How can your loved ones prepare for an inheritance?

When it comes to inheritance, thoughtful planning and proactive measures can greatly ease the process for your loved ones.  By preparing your loved ones beforehand, you not only streamline the inheritance process but also provide them with the tools and knowledge to manage these assets responsibly and in accordance with your wishes.  From organizing essential documents to introducing family members to your financial planner, this article offers 3 suggestions to help prepare your loved ones for their inheritance.  

Should you worry about inheritance tax implications?

When you are expecting an inheritance or have inherited assets, it is important to consider the tax implications that come with it. Depending on the size and complexity of the estate, you may need to consult with an estate planning attorney or a tax professional to understand the potential tax liability you may face.  Inheritances can be subject to various taxes, including federal estate tax and capital gains tax, so it’s crucial to plan for your inheritance accordingly. If you receive an inheritance, you may need to work with a tax advisor to ensure you are properly distributing and managing your assets to meet your financial goals.

Inheriting an IRA

One common scenario is inheriting an IRA, which can have its own set of tax consequences. An inherited IRA may require you to pay taxes on distributions, so it’s important to seek tax advice in order to minimize your tax burden. Additionally, if you inherit a house or other valuable assets, you may be responsible for capital gains tax if you decide to sell them. Overall, understanding the tax rules surrounding your inheritance could significantly impact your financial plan and financial life.

  1. Traditional IRA: If you inherit a traditional IRA, the distributions you receive are generally taxable as ordinary income. The taxation depends on several factors:
    • If you inherit the IRA as a spouse, you have more options. You can treat the inherited IRA as your own by rolling it over into your own IRA or electing to treat it as an inherited IRA. If you choose to treat it as your own, you won't have to take required minimum distributions (RMDs) until you reach the age of 72 (as of 2024). If you choose to treat it as an inherited IRA, you'll need to start taking RMDs based on your own life expectancy or within ten years of the original owner's death if they passed away after December 31, 2019.
    • If you inherit the IRA as a non-spouse beneficiary, you generally have to start taking RMDs based on your own life expectancy or within ten years of the original owner's death if they passed away after December 31, 2019. The distributions you receive are taxable as ordinary income.
  2. Roth IRA: If you inherit a Roth IRA, distributions are generally tax-free if the original account holder held the Roth IRA for at least five years before their death. If you inherit a Roth IRA as a spouse, you have similar options to a traditional IRA, but if you inherit it as a non-spouse beneficiary, you're typically required to take RMDs within ten years of the original owner's death.

What if you inherit a house?

When someone inherits an asset, such as stocks, real estate, or other investments, the cost basis of that asset is typically "stepped up" to its current market value at the time of inheritance rather than the original purchase price.

The step-up in cost basis has important tax implications, particularly for capital gains taxes. Capital gains taxes are calculated based on the difference between the sale price of an asset and its cost basis. By stepping up the cost basis to its current market value at the time of inheritance, any appreciation in the value of the asset that occurred before the inheritance is essentially excluded from capital gains tax calculations.

How Often Should You Update Estate Documents?

Think of your estate documents, such as a trust, as a roadmap that outlines how you want your belongings and assets to be handled once you're no longer around. Laws related to estates, taxes, and inheritance are a lot like the rules of a game—they can change over time. When these rules change, it might affect how your plan works.

Estate attorneys recommend reviewing and updating your estate documents every 3-5 years because during this time, laws can be updated or new ones might come into effect. These changes could impact how your estate plan operates, potentially affecting things like taxes, who gets what, or how your assets are distributed.

By staying on top of these updates, you can ensure that your plan remains aligned with your wishes and that it works as you intended. It's a way of keeping your plan in tune with the current rules, safeguarding against any unexpected outcomes, and making certain that your loved ones are taken care of according to your desires, regardless of how the rules change.

How to Make it Easy for Your Loved Ones?

Making it easy for your loved ones to inherit your assets involves some organization and planning. One way to simplify the process is by reducing the number of accounts and institutions you're dealing with. Consider consolidating accounts where possible—like bank accounts, investment accounts, or retirement funds—so that there are fewer places for your loved ones to search for assets.

Additionally, creating a centralized vault for all your estate documents, whether physical or cloud-based, can significantly ease the process for your family. You can gather important documents like your will, trust documents, insurance policies, deeds, account information, and any other relevant paperwork in one secure place.

For a physical vault, you might use a secure filing cabinet, a safe, or a specific drawer where all these documents are stored together and clearly labeled. Alternatively, using a cloud-based vault or digital storage solution allows you to store scanned copies or digital versions of these documents securely online, accessible to authorized individuals.

Having all these documents organized and in one place ensures that your loved ones know exactly where to find everything they need when the time comes. It reduces the stress and hassle of searching through various places or accounts to locate important information and streamlines the inheritance process for them during a potentially difficult time.  

What are essential estate planning documents?

  1. Will: This document outlines how you want your assets to be distributed after your passing. It can also designate guardianship for minor children and name an executor to manage the estate.
  2. Trust: Trusts provide more control over how assets are distributed. They can be revocable or irrevocable and allow for specific conditions on asset disbursement.
  3. Power of Attorney: This legal document designates someone to make financial decisions on your behalf if you're unable to do so. It can cover financial, legal, or healthcare matters.
  4. Healthcare Directive (Living Will): A living will expresses your healthcare wishes if you're incapacitated and unable to communicate. It outlines preferences for medical treatment, end-of-life care, and organ donation.
  5. Beneficiary Designations: Assets like life insurance policies, retirement accounts, and certain bank accounts pass directly to named beneficiaries. Review and update these designations regularly.
  6. Letter of Intent: While not a legal document, it can provide guidance for your executor or trustee about your wishes that aren't explicitly addressed in other documents. It can cover sentimental items, funeral arrangements, or specific instructions.
  7. List of Assets and Debts: A comprehensive inventory of your assets and debts helps your executor handle your estate efficiently. Include bank accounts, real estate, investments, debts, and digital assets.
  8. Guardianship Designation: If you have minor children, a document designating guardianship outlines who will care for them if you pass away.
  9. Business Succession Plan: If you own a business, a plan for its future management or transfer is crucial for a smooth transition.

Introduce your financial advisor

Introducing your loved ones to your financial planner is a way to ensure that they have the necessary support and guidance after you're no longer around. Financial planners are experts in managing money, investments, and estate planning. By familiarizing your family with your financial planner, you're providing them with a valuable resource they can turn to for advice and assistance.

Now, if your loved ones aren't particularly savvy with handling money or don't have much experience managing wealth, considering a trust with a corporate trustee can be a smart move. A corporate trustee is a professional entity, like a bank or a trust company, that manages the assets placed in the trust according to your instructions.

This can be beneficial for a few reasons:

  1. Expertise and Experience: Corporate trustees have the expertise to manage complex financial matters. They can make sound investment decisions and ensure that your assets are handled wisely, even if your loved ones lack financial know-how.
  2. Objectivity: A corporate trustee can act impartially, making decisions based on the terms of the trust rather than emotional attachments, which can sometimes cloud judgment within a family.
  3. Consistency and Continuity: Corporate trustees have a structure in place to ensure continuity in managing the trust, which might be lacking if individual family members were to take on this responsibility.
  4. Risk Mitigation: They can help protect the trust from potential mismanagement or financial risks that could arise if an inexperienced family member were to manage the assets.

By setting up a trust with a corporate trustee, you're essentially creating a safety net. It ensures that your assets are managed responsibly and according to your wishes, especially if your loved ones might struggle with the complexities of wealth management. And introducing your family to your financial planner can further empower them by providing a trustworthy resource for guidance and support in navigating these matters.

About Daniel Masuda Lehrman

I am a Fee-Only Fiduciary and Founder of Masuda Lehrman Wealth LLC. Prior to starting my own firm, I was a Vice President Financial Consultant at Charles Schwab in their Downtown Honolulu office. I have worked in financial planning for 10 years at Vanguard, Fidelity, and Schwab. I'm a CERTIFIED FINANCIAL PLANNER™ professional (CFP®) and Certified Student Loan Professional with an Economics degree from the University of Michigan.

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